As all contractors are aware, being caught inside IR35 can lead to a significant reduction in take-home pay. However, if found inside IR35, pensions can come to a contractor’s rescue and minimize the tax shock of being inside IR35. The biggest advantage with pensions is that any pension contributions are counted before calculation of taxes.
Let’s look at how pensions minimize the effect of being inside IR35 for different income levels. We look at the different scenarios using the example of Tim, a fictitious contractor. Note that for all calculations, we have kept Value Added Tax (VAT) out of the equation.
Tim charges £35 an hour to his clients. Let’s say he works for 40 hours every week, and 48 weeks every year, resulting in annual revenues of £67,200. Tim pays himself an annual salary of £7,000 and has annual expenses of £12,000.
On this income, after accounting for corporation tax and tax on dividends, Tim is left with a take-home pay of £55,948.18, which is 83.26% of his total revenues. So in all, Tim has paid total taxes of £11,252 (£67,200 - £55,948).
Assuming the same annual income of £67,200, we look at Tim’s tax payable and take-home pay if he’s found inside IR35.
After accounting for National Insurance (both the employer’s and employee’s contributions), administration expenses, personal income taxes, and tax on dividends, Tim gets a take-home pay of £43,921.56. This amount is 65.36% of the total income and is a result of £23,278.44 (£67,200 - £43,921.56) paid in taxes.
As you can see, Tim is paying nearly £12,026.44 (£23,278.44 - £11,252) more in taxes by being inside IR35.
One of the reasons for the high taxes inside IR35 (as opposed to being outside IR35) is the high taxable income. As you know, for contractors inside IR35, a large portion of their income is considered as salary and requires deduction of PAYE income tax and National Insurance contributions similar to that of full-time employees.
In this example, with annual revenues of £67,200, Tim’s salary will be considered as £54,110.66. This is after deducting employer’s NICs of £6,369.34, administration expenses of £3,360 or 5% of total revenues, and an employer NIC adjustment of £3,360. After deducting a personal allowance of £10,000, the taxable income is £44,110.66 (£54,110.66 - £10,000). This taxable income results in a PAYE income tax of £7,271.26 and employee National Insurance of £5,538.56 or total deductions of £12,809.82 (£7,271.26 + £5,538.56) from salary.
With a similar income and expenses, let’s see what happens if Tim invests £24,000 in pension. With a pension investment, Tim’s annual take-home pay inside IR35 works out to £34,891.15. While it may seem lower than £43,921.56, this figure doesn’t include the £24,000 which have been already saved from taxes by investing in a pension. So technically the take-home pay inside IR35 is £58,891.15 (£34,891.15 + £24,000), which is nearly 34% higher than £43,921.56, the take-home pay inside IR35.
With pensions, Tim is even able to get a higher-take home pay (£58,891.15) than he would have received outside IR35 (£55,948.18).
Let’s say Tim charges an hourly rate of £50 and works for 45 hours a week. In a year, he works for 48 weeks, resulting in an annual income of £108,000. He pays himself a salary of £7,000 and has annual expenses of £24,000.
On this income, Tim gets an annual take-home pay of £85,228.18 by being outside IR35. This amount is 78.91% of the total take-home pay after accounting for corporation taxes and tax on dividends. Tim is paying a total tax of £22,771.82.
With a similar income, Tim’s take-home pay inside IR35 will be £55,413.68 or 51.31% of total income. This results in taxes of £52,586.32 (£108,000 - £55,413.68).
The high amount of taxes includes employer’s NICs of £10,822.21. After adjustment for employer’s NICs and administration expenses, Tim gets a net salary of £86,377.79. On this salary, Tim has to pay income tax of £20,178.12 and employee NICs of £9,410.62.
Let’s say Tim makes a pension contribution of £3,350 every month or an annual pension contribution of £40,200.
With the pension amount, Tim’s take-home pay works out to £44,243.21 or 40.97% of total income. Again as illustrated above, if you add savings of £40,000, the take-home pay is much higher at £84,243.21 (£44,243.21 + £40,000). This amount is £28,829.53 or nearly 52% more than the take-home pay of £55,413.68 without a pension.
Like in the example with income below £100,000, the higher take-home pay is a result of lower taxable salary, which results in lower PAYE income tax and lower National Insurance contributions. Because of the pension contribution, PAYE income tax and National Insurance contributions are calculated on a salary of £51,052 as opposed to £86,377.79 without a pension.
This take-home pay is again very similar to the take-home pay outside IR35.
Note that you can invest only a maximum of £40,000 every year in pension to claim tax benefits. There is no tax advantage for pension investment above £40,000.
As you can see, savings in pensions can significantly increase the take-home pay of those inside IR35. As seen in one of the examples above, pension savings can even fully eliminate the tax shocks of being inside IR35.
It can get slightly tricky for the average contractor to calculate the impact of pension contributions on their take-home pay. You can use our IR35 calculator to calculate how pension contributions affect take-home pay and lead to tax savings.
All the calculations above have been done using one of our online IR35 calculators.
If you are a contractor / freelancer and you are looking to find the right, compliant and tax effective accounting solution then either request a callback on contact us on 0203 137 9246. A pension is just one example of how our accountants and tax experts can help you make the most of your money.